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This is cross-posted at the Wealth and Risk Management Blog
It’s doubtful that anybody in the Financial Services industry is unaware of qualified retirement plans such as 401(k)s and IRAs. Knowledge of them is required to pass licensing exams and every firm includes them in sales literature. Non-qualified plans (NQDC), however, are less well-known, largely because they are more complex and appeal to a far smaller group of potential buyers. Although their application is narrower, in the right circumstances they can provide clients with tremendous advantages. This post begins a series on NQDC. We will be spending a large amount of time with the tax code and accompanying treasury regulations; this is necessary due to NQDC’s complexity and numerous regulations. But before delving into the code, let’s use basic statutory analysis and analyze the “plain meaning” of the words, beginning with “non-qualified.” The primary difference between NQDC and qualified plans is that the former don’t comply with §401’s safe harbors – especially the rules relating to “highly compensated individuals”[1] and the plan funds not being subject to the plan sponsor’s general creditors.[2] In fact, the treasury regulations define NQDC as much by what it isn’t[3] as what it is. Moving onto the other words, the Merriam Webster online dictionary defines the word “deferred” as “withheld for or until a stated time”[4] and “compensation” as “payment.”[5] Combining these two definitions, we get: payment for services that is withheld until specifically enumerated events. A properly implemented NQDC plan requires that the client does not formally receive income before certain events[6] or else he will become liable for the accompanying taxes at inopportune times (along with penalties). Therefore, we need to know when a taxpayer recognizes income to avoid attribution from these events. This naturally leads to a discussion of the two accounting methods. The cash method stipulates that “all items which constitute gross income … are to be included for the taxable year in which actually or constructively received.”[7] The most obvious example occurs when the taxpayer’s account increases by a specific amount of money. The accrual method is the second system. It has two factors: all events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.[8] For example, once the taxpayer has done the agreed upon work and sent an invoice, he can book the income under the accrual method. The client must also avoid constructively receiving income, which is defined in §1.451-2(a): Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. The service provider cannot reach, attach, pledge, or be credited with all or any portion of the money set aside under the plan. This requires that all funds in the NQDC plan be subject to a substantial risk of forfeiture, which is discussed in treasury regulation §1.83-3(a). a substantial risk of forfeiture exists only if rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or upon the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial. The most commonly used situations in NQDC contracts are continued performance by the service provider or the occurrence of a major corporate event such as a merger or acquisition, specific sales goals, going public, and the like. This post only covers the surface of several key NDQC components. However, it should provide the reader with a basic overview of these key elements. Next, we’ll dig deeper into the definition of an NQDC plan. [1] 26 U.S.C. 401(a)(4) [2] See 26 U.S.S. 401(a)(2) [3] The Treasury regulations define NQDC by what it isn’t. See generally Treas. Reg. §1.409A-1(a)(2)(i) through Treas. Reg. §1-409A-1(2)(ix) [4] https://www.merriam-webster.com/dictionary/deferred [5] https://www.merriam-webster.com/dictionary/compensation [6] 26 U.S.C. 409(A)(2)(A)(i)-(vi) [7] Treas. Reg. §1.446-1(c)(i) [8] Treas. Reg. §1.446-1(c)(ii) Over the last few months, I’ve documented a series of cases where courts forced grantors of a foreign asset protection trusts to disgorge assets despite placing this fund into a “bulletproof” offshore structure. Those who continue using FAPTs offer the following rebuttals to the case law.
First, offshore trust proponents point to the unsavory character of the grantors in the case law. This is entirely accurate; the cases involve people convicted of fraud, securities laws violations and other crimes. The implication of this observation is that a client using a FAPT who isn’t a criminal would stand a better chance of surviving a creditors attack. This argument is unconvincing. The case's judicial reasoning was made independent of the facts, instead resting on public policy. Second, offshore trust promoters argue that these cases largely involve “super-creditors” (primarily government agencies) who used their statutory powers to achieve a result unavailable to non-governmental actors. This is also unconvincing, largely for the reason given above: courts ruled against debtors based on public policy. Judges did not want to be seen as allowing debtors to “have their cake and eat it, too.” This conclusion could just as easily be reached for a private actor. Third, offshore trust proponents note that these decisions occurred long past the point when most other creditors would have given up or settled. This is a good argument. The FAPT failures (as I call them) occurred at the end of 7, 8 and 10-year cases, largely undertaken by government agencies whose goal was to make victims whole. This explains why they were more than willing to engage in protracted and complex litigation. It’s distinctly possible that private creditors would have settled these cases long before the government actors. And this is a key takeaway. FAPTs failures only occurred after extensive, complex and expensive litigation. Not all creditors will pursue a debtor this aggressively, opting instead to settle for a lower dollar amount. But the tables aren’t exactly pro-debtor either, because, should a creditor take aggressive action, he can refer to the FAPT failure cases to eventually force a debtor to repatriate funds. So, should you still use FAPTs? Only as the very last piece of an asset protection plan. And then, only with a smaller percentage of the client’s assets – probably 25% at the most. A Brief Overview of the Judicial Reasoning That Has Thwarted Foreign Asset Protection Trusts10/10/2017
As I have documented (here, here, here, here, and here) there are several cases where courts have ruled against the grantors of a foreign asset protection trust, thereby nullifying the asset protection benefit. In this post, I want to briefly sum up the judicial reasoning used by the courts to thwart these trusts.
Some offshore jurisdictions have amended their code to include provisions such as shortening the fraudulent transfer statute of limitations or not recognizing foreign judgments. Seeking to take advantage of these debtor-friendly rules, drafting attorneys typically add a choice of law provision to trust documents, stating that the haven’s rules will apply to their trust and its interpretation. This drafting tactic is supported by Scott on Trusts, which states that the grantors choice of law designations should generally be respected. But as the Portnoy court observed, the Restatement of the Conflict of Laws allows courts to overturn a trust’s choice of law clause if, “…required by the policy of a state.” The court continued, “application of Jersey’s substantive law would offend strong New York and bankruptcy policies if it were applied,” followed by this intellectual coup de grace: New York would not “permit a debtor to shield from creditors all of his assets because ownership is technically held in a self-settled trust, where the settlor beneficiary nonetheless retains control over the assets and may effectively direct disposition of those assets.” The policy is clear: courts won’t allow debtors to run up large obligations, default, and then not provide creditors a legal avenue to be made whole. Not only is this ethically and politically unsavory, its economically inefficient and poor public policy. Courts will not allow themselves to be a party to a transaction that allows debtors to “have their cake and eat it too.” Long ago, attorneys recommending foreign assets protection trusts (FAPT) realized that courts might hold grantors in contempt because they wouldn’t repatriate assets from a foreign jurisdiction. To theoretically thwart this possibility, drafters included a “duress clause” in trust indentures. When a “duress” event occurs (such as a judge forcing the grantor to repatriate assets), the grantor will either be stripped of all his trust benefits or the trustee will be allowed to deny the request. The cases contain the following general fact pattern: the court threatens the grantor with contempt; the grantor asks the trustee for a distribution; the trustee uses the duress clause to deny the distribution; the grantor than tells the court, “I tried to comply but couldn’t.” But judges have read the relevant literature and are fully aware this is a case of artful drafting. Therefore, they impose a very high burden on the grantor when he creates the “impossible” situation. The court in Affordable Media observed: With foreign laws designed to frustrate the operation of domestic courts and foreign trustees acting in concert with domestic persons to thwart the United States courts, the domestic courts will have to be especially chary of accepting a defendant's assertions that repatriation or other compliance with a court's order concerning a foreign trust is impossible. Consequently, the burden on the defendant of proving impossibility as a defense to a contempt charge will be especially high In effect, the courts treat the grantors pre-planned failed compliance effort as kabuki theater. There is always a possibility that a grantor could overcome the court’s “especially high” bar. But it seems doubtful. In the final installment of this series on foreign asset protection trusts, I’ll look at if and when someone should use these structures. From Wealth Management.com
In a report issued on Oct. 2, 2017, Treasury Secretary Steven Mnuchin recommended that the proposed Internal Revenue Code Section 2704 regulations be withdrawn. Those regs would have restricted the use of partnerships and other entities to generate valuation discounts. The Internal Revenue Service had released a proposal in August 2016 in an attempt to limit what it perceived as an erosion of the applicability of Section 2704 and the creation of artificial valuation discounts. A hearing was held on on Dec. 1, 2016. Almost 30,000 formal comments were submitted to the Treasury. The report states: “Treasury and the IRS now believe that the proposed regulations’ approach to the problem of artificial valuation discounts is unworkable…. The proposed regulations could have affected valuation discounts even where discount factors, such as lack of control or lack of a market, were not created artificially as a value-depressing device.” It goes on to say that: “Treasury and the IRS plan to publish a withdrawal of the proposed regulations shortly in the Federal Register.” |
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